Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.
Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheet of Microsoft MSFT, in order to get some clues as to how well this company is doing.
I will go through the balance sheet, reviewing the most important items, in order to assess Microsoft's financial condition. The information that I am using for this article comes from Microsoft's website here. Note that this article is not a comprehensive review as to whether Microsoft should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.
This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.
Microsoft is a company whose products and services are familiar to just about everyone. The company is split into five divisions. Their Windows division produces the Windows PC operating systems, along with PC software and hardware products. Their Server and Tools division offers technology and related services that help IT professionals become more productive. The products offered by this division include Windows Server, Microsoft SQL Server, and Visual Studio. Their Online Services division markets information and content to help people make decisions online. Included in this division are the popular search engine, Bing, as well as MSN. The Microsoft Business division offers software to increase personal and organizational productivity. This software includes the popular Microsoft Office. Their Entertainment and Devices division includes products like the Xbox 360 gaming console, Skype, and the Windows Phone.
Microsoft has a market capitalization of $233B and has recorded over $73B in sales over the last 12 months. 24% of its sales over the last 6 months came from the Windows division. 26% of its sales came from its Server and Tools division. 30% of sales came from the Business division, while 15% of sales came from Entertainment and Devices, and 4% of its sales came from its Online Services division.
Cash and Cash Equivalents
The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, pay down debt, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.
As of Dec. 31, 2012, Microsoft had $68.3B in cash and short-term investments, which can be easily converted into cash. This is a lot of cash for a company that has a market cap of $233B. This means that the company is trading for less than four times its cash position, which can be very attractive for value-oriented investors. Over the last 12 months, Microsoft repurchased $3.41B worth of stock, and paid out $6.97B in dividends. These activities are both well-supported by its trailing 12-month free cash flow of $27.7B.
Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.
Microsoft had a total of $14.3B in net receivables on its balance sheet, which represents 19.6% of its trailing 12-month sales of $73B. For fiscal 2012, which ended on June 30, 2012, 21.4% of its sales were booked as receivables, while that percentage was at 21.5% for fiscal 2011.
While 19.6% might be considered a relatively high percentage for receivables, it appears to be pretty consistent with the company's history over the last couple of years, so I'm not too worried about this.
Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of its operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.
If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.
The current ratio of Microsoft is 2.81, which is outstanding.
Property, Plant, and Equipment
Manufacturing, like any other industry, requires a certain amount of capital expenditure. Land has to be bought, factories have to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant, and equipment, as companies that constantly have to upgrade and change its facilities to keep up with competition may be at a bit of a disadvantage.
However, another way of looking at it is that large amounts of money invested in this area may present a large barrier-to-entry for competitors. Right now, Microsoft has $8.7B worth of property, plant, and equipment on its balance sheet. This figure is slightly above the $8.3B that the company reported 6 months ago, and the $8.0B that they reported 12 months ago.
Given the consistency of its position here, I don't see anything to be concerned about.
Goodwill is the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case by case basis, as good companies are rarely purchased at or below book value.
Microsoft has $14.7B worth of goodwill on its most recent balance sheet, which is a bit higher than the $13.5B worth of goodwill that it reported 6 months prior. $937M of this $1.2B increase stems from its $1.1B acquisition of enterprise social networks provider, Yammer.
However, their $14.7B in goodwill is significantly lower than the $19.7B that they reported 12 months ago. This is due to a $6.2B write-down that occurred six months ago in connection with its $6.3B purchase of online advertising company, aQuantive in 2007. Management determined that this acquisition did not expand the company's online advertising business, so virtually the entire purchase price of the company was written off of the balance sheet. This was a really bad bet by management, but hopefully, they've learned their lesson.
Overall, goodwill accounts for about 11% of Microsoft's total assets of $129B. Usually, I don't like to see goodwill account for more than 20% of a company's total assets for the reason that I discussed above. Since Microsoft is well below that threshold, I don't see much need to panic here, unless they make more bad moves like the one with aQuantive.
Intangible assets that are listed on the balance sheet include items such as licensed technology, patents, brand names, copyrights, and trademarks that have been purchased from someone else. They are listed on the balance sheet at their fair market values. Internally-developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating their net worth by slapping any old fantasy valuation onto their assets. Many intangible assets like patents have finite lives, over which their values are amortized. This amortization goes as annual subtractions from assets on the balance sheet and as charges to the income statement. If the company that you are researching has intangible assets, with finite lives, that represent a very large part of its total asset base, then you need to be aware that with time, those assets are going to go away, resulting in a reduction in net worth, which may result in a reduction in share price, unless those intangible assets are replaced with other assets.
Microsoft currently has $3.34B worth of intangible assets on its balance sheet. This is a slight bump from the $3.17B that it had 6 months prior. This increase is due to the $178M in intangible assets that it got in its acquisition of Yammer. Their intangible assets can be divided into three categories. They are technology-related, customer-related, and marketing-related. The bulk of the intangible assets are in the technology and customer-related areas. Most of these intangible assets will be lost to amortization over the next 4 years. While the amortization of $3.54B worth of intangible assets over the next 4 years isn't a good thing for the balance sheet, I am not too concerned about it, as these assets account for less than 3% of the company's total assets.
Return on Assets
The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:
Return on Assets = (Net Income) / (Total Assets).
For Microsoft, the return on assets would be $23.4B in core earnings over the last 12 months, divided by $129B in total assets. This gives a return on assets for the trailing twelve months of about 18.1%, which is really good, especially when considering that a huge asset base of $129B serves as a good barrier-to-entry. I also calculated Microsoft's returns on assets over fiscal years 2012, 2011, and 2010 for comparative purposes. This can be seen in the table below.
Table 1: Nice Returns On Assets From Microsoft
These are really good returns on assets that are fairly consistent, although they are creeping in the wrong direction. This is due to the fact that while their earnings are growing, their asset base is growing faster, which isn't necessarily a terrible thing. I see nothing to worry about here.
Short-Term Debt Versus Long-Term Debt
In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.
However, Microsoft doesn't have much to worry about here, as it reported just $2.24B of short-term debt on its most recent balance sheet. And, as I discussed earlier, Microsoft has more than enough current assets on hand to meet this, along with other current obligations.
Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.
Right now, Microsoft carries $11.9B of long-term debt.
In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of the company's core earnings over the last 3 fiscal years. The average core earnings of Microsoft over this period is $21.7B. When you divide the long-term debt by the average earnings of the company, here is what we find.
Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings
For Microsoft, here is how it looks: $11.9B / $21.7B = 0.55 years
This is fantastic for Microsoft, in that it can pay off its long-term debt with less than one year's worth of earnings. If it wanted to, it could also dip into its cash to pay it off. Before I leave this section, I should mention that about half of its long-term debt is due within the next 6 years, but due to the company's strong earnings and cash position, I see nothing to worry about here.
The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Microsoft stacks up here.
Debt-To-Equity Ratio = Total Liabilities / Shareholder Equity
For Microsoft, it looks like this: $56.1B / $72.6B = 0.77
Microsoft's debt-to-equity ratio also looks pretty decent. To see how this figure has changed over time, I have included it from the ends of the last three fiscal years in the table below.
Table 2: Debt-To-Equity Ratios Of Microsoft
From the looks of this table, the debt-to-equity ratio of Microsoft is slowly moving in the right direction, and it has been consistently good. So, from a debt-to-equity standpoint, I don't see anything to be worried about at the moment.
Return On Equity
Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.
Return On Equity = Net Income / Shareholder Equity
Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. However, Microsoft is not one of these companies.
So, the return on equity for Microsoft is as follows:
$23.4B / $72.6B = 32.2%
This is a pretty solid return on equity. In the table below, you can see how the return on equity has fared over the past three years.
Table 3: Returns On Equity At Microsoft
The return on equity at Microsoft has been really good over the past three years, although it has been creeping lower over the time in question, due to the company's equity growing at a faster rate than its core earnings (which are also rising), which isn't necessarily a bad thing.
Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:
Retained Earnings = Net Income - Dividend Payments - Stock Buybacks
On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.
There is a very interesting peculiarity with Microsoft in this department. As you can see in the table below, Microsoft reported negative retained earnings in 2010 and 2011. Looking back in the financials of the years before that, the company ran even bigger deficits in retained earnings.
Table 4: Retained Earnings At Microsoft
These deficits in retained earnings stem largely from a whopping $32B, $3 per share, special dividend that was paid out to shareholders during fiscal 2005. There were also numerous stock repurchases dating back to that period that contributed to this deficit. Management addressed this issue in some of their SEC filings by saying that the deficit in retained earnings will not affect the company's operations due to its strong cash position and earnings power. Given that the company has added over $22B in retained earnings in just the last three years, creating a surplus of over $4B, it appears that management was right here.
After reviewing the most recent balance sheet, it can be concluded that there is much to like about the financial condition of Microsoft. It has a large amount of cash and short-term investments that can be used for acquisitions, debt retirement, dividends, and share repurchases, in addition to a strong level of free cash flow. An excellent current ratio shows that the company can meet its short-term financial obligations, even in the event of an unlikely disruption of its operations. Microsoft's short and long-term debt positions are easily managed by its large cash position and earnings power. The company has shown very good returns on assets and returns on equity, along with very good growth in retained earnings over the last three years that the company can invest for future growth.
While this is not a comprehensive review as to whether Microsoft should be bought or sold, it can certainly be said that Microsoft is in excellent financial condition.
To learn more about how I analyze financial statements, please visit my new website at this link. It's a new site that I created just for fun, as well as for the purpose of helping others make good financial decisions.
Thanks for reading and I look forward to your comments!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.